This article aims to use a bargaining power model to reduce moral hazard—in the form of entrepreneurial effort shirking—and derive an optimum sharing ratio of a Profit and Loss Sharing (PLS) contract that involves a Venture Capitalist and an Entrepreneur. The model reveals the following interesting findings. First, under complete information—where the Venture Capitalist has a bargaining power ‐ Venture Capitalist offers the entrepreneur a profit sharing ratio that is less than her capital contribution ratio. Second, in an incomplete information setting, the entrepreneur demands a profit sharing ratio higher than her capital contribution ratio when the sum of the marginal cost (from exercising a higher effort) and private benefits (from exercising a low effort) is greater than the marginal return (from exercising a high effort). In addition, the model is used to derive a span of negotiation about the profit sharing ratio. Finally, an agent based simulation (Netlogo) platform is considered to implement the model, which allows a faster numerical calculations of the profit share and helps decide on the validity of the funding contract.

In this paper, we try reducing the moral hazard of profit misreporting in Profit and Loss Sharing Contract (PLS). In this kind of contracts , the corporate manager has a temptation to misreport profits which can lead to either project failing or to financiers receiving an unfair allocation of profits. To help in solving this problem we propose a new model that includes a real option that gives the corporate manager (agent) the right, but not the obligation, to gradually buy shares in the corporation from the financier/bank. We compare our results with the standard case of PLS without real options. We show, using a multi-agent simulation (Netlogo) that embedding real options in the PLS contract can reduce the profit misreporting case. The fact that PLS contracts are riskier compared to other forms of financing such as debt, provides an incentive for the creation of models that reduce their risk to capital providers. Given the results obtained from our real options model, the latter could prove to be of practical use to financial institutions willing to engage in PLS financing.

PLS contracts, Like Musharakah in participative finance, represent a practice of profit and loss sharing contracts. It is claimed to be a fair economic mode of investment as it entails the sharing, by the participants, of profits and risks. This mode of financing, however, suffers from asymmetric information in the form of adverse selection and moral hazards. In this Agent based simulation we managed to apply a repeated game theoretical approach to PLS financing using an agent based simulation tool called Net- logo. The purpose is to test whether PLS contracts are representative of a prisoner’s dilemma game. We have identified different parameters which are used to calculate the payoffs of the bank and the enterprise which seeks financing. Each agent in this simu- lation has some strategies that he/she can use through the game. We have managed to run the simulation1000 times for different model parameters under each combination of the agent’s strategies. We have found evidence that PLS contracts are not represen- tatives of a a prisoner dilemma game as mutual cooperation does not lead to a better payoff to the corporation than mutual defection. Over a repeated process, however, we found simulation evidence that the threat by the bank to apply an unforgiving strat- egy towards defection, leads to a cooperative behavior by the corporation through the strategy Tit-for-Tats.

In this paper two models are contrasted whereby a corporation is seeking to finance the purchase of a merchandise from a supplier through a profit and loss sharing contract.The first mode consist of financing the purchase totally through equity. The second model is a new hybrid model that engages the supplier in the process as a shareholder.Both models are based on the principle of profit and loss sharing which suffers from the issue of moral hazard.This is manifestedin the form of the corporation shirking (providing low effort) and/or misreporting profits. It is argued that under equity financing, where the financier is the only shareholder, the corporation can hide part of the merchandise it sold and therefore misreport profits. This is, however, not possible under hybrid financing where, in addition to the financier, the supplier is interested in the financial reporting of the corporation. We apply a game theoretical approach where ,under a hybrid financing, the financier and the supplier have mutual interest in true revenue reporting and therefore constitute a coalition (one player) against the corporation. Our game incorporates the effect of sharing markets and corporations' discounts between the game participants under each model. We showtheoretically that a non-conditional good Nash equilibrium exists under hybrid financing. This case does not apply to an all equity financing where the existence of a good Nash equilibrium is conditional upon the financier and the supplier sharing ratios. This shows that under the hybrid model the corporation is always induced to provide more effort (not shirk) and truly report profits.

PLS contracts in Islamic finance are fair economic practices as they focus on sharing profits and loss between the project’s participants. Despite its ethical dimension, moral hazards and adverse selection are the paramount risks in this type of contracts. In this paper we seek reducing moral hazards in the form of the entrepreneur’s effort shirking and if a project optimum lifetime can be identified. To answer these questions, we use a game theory approach in one stage and in a repeated framework. Under each scenario, the participants either fix the capital contributions or negotiate over the sharing ratio or vice-versa. We found theoretical evidence that cooperation can be sustained over a one period game. Cooperation can be sustained in a repeated game only if an appropriate monetary incentive is introduced. However, this incentive can only be given for a specific period before the project’s NPV starts to drop. Indeed, we managed to find that period, called duration, for which the financier NPV is maximized. This duration can be proposed to be used as the optimum lifetime of the contract.